Alumni refresher lecture series
Understanding global imbalances
Far from being unsustainable, the large and growing US current account deficit is likely to endure for some years – and Australia shares some of the key features of the United States
The large and growing US current account deficit has elicited increasing concern, even alarm, and claims that it is unsustainable. This lecture argues that the large US deficit is a natural consequence of two significant worldwide developments – demographic change and globalisation of financial markets. Far from being unsustainable, it is likely to endure for some years. Serious efforts to reduce it significantly are likely to do more harm than good. While the focus is on the US deficit, Australia could be substituted for the US and much of the argument would still apply. Although smaller in scale and better endowed with natural resources, Australia shares some of the key features of the US.
The key ‘laws’ of economics
Like physics, economics has its ‘laws’ that cannot be broken. The key laws of economics are accounting identities – adding up requirements – that must be satisfied when contemplating any change from any observed situation. Much of economics is devoted to the study of behavioural regularities, but these may vary in important detail from place to place and from time to time. The accounting identities must always be satisfied. Yet much public and journalistic discussion ignores them, and thus implicitly contemplates changes that are not in fact viable.
Three accounting identities will inform this lecture and, I hope, throw light on the origin and the sustainability of the current pattern of world imbalances. The first is that, apart from measurement errors, which may be substantial, any country’s current account balance must equal the difference between its total expenditure and its total output or, equivalently, between its domestic investment and its national savings. The second is that current account balances around the world must sum to zero – again, apart from measurement errors. The third is that a country’s current account balance is equal, with usually minor qualifications, to its net foreign investment. Thus, a country in current account deficit must be experiencing a net inflow of capital from abroad. The US current account deficit must be judged in light of these three accounting identities.
Current account deficits and surpluses
The US current account deficit has grown significantly in recent years to around $800 billion or six per cent of GDP in 2006. (It declined modestly in 2007 in response to a slowdown of the US economy and a depreciation of the US dollar.) Many attribute this growth to a decline in US savings, and argue that savings must be increased to reduce the deficit. But the decline in US savings accounts for only a portion of the rise in the US deficit. Moreover, the US economy is part of a complicated, independent global system. Raising US savings by itself (e.g. through higher tax rates) would not necessarily reduce the current account deficit, or might reduce it in an undesirable way, for example by causing a US recession. The US deficit has its exact counterpart in surpluses elsewhere, implying excess savings in the rest of the world. Raising US savings will not automatically reduce savings or increase investment elsewhere, and might indeed have the opposite effect. We must address why those surpluses exist, and how easily they will decline, as they must do if the US deficit is to be reduced.
One reason for large savings elsewhere is the sharp increase in oil prices since 2002, greatly augmenting the revenues of oil-exporting countries. These surpluses are likely to decline in the coming years, as revenues move into the income stream of the oil-exporting countries and into imports, and as oil prices decline.
But oil-exporters are not the only countries in surplus. So are China, Japan, Germany, and a host of smaller European and East Asian countries. These countries are going through dramatic demographic change, with increasing longevity and birth rates well below replacement rate. These developments, other things equal, are likely to sustain savings but weaken domestic investment in such countries, as the need for housing, schools, and equipment for new entrants of the labour force declines. Returns to capital are also likely to be depressed. Residents of these countries have an incentive to place some of their savings abroad, to build assets for retirement, implying current account surpluses. China, while experiencing similar demographic change, is in a different situation from the rich countries, in that it will continue to experience significant rural-to-urban migration and will thus need to house and equip the new urban workers, as well as upgrade the housing of urban Chinese as they become richer.
As globalisation proceeds, the traditional bias toward allocating saving at home will decline, more information on the possibilities for foreign investment will become available, and institutions will respond to increased interest by making it easier for citizens in one country to invest in another. Thus globalisation of financial markets will reinforce demographic change as a factor leading to greater foreign investment. Net foreign investment abroad will necessarily be reflected in a current account surplus, and, similarly, the net recipients of net inward foreign investment will run a current account deficit, as both Australia and the US do.
Destinations of foreign investments
Why invest in the US? Net foreign investment by saving-surplus countries takes place in many places, not just in the US. Yet it accounts for over a quarter of gross world product, and for roughly half of marketable financial securities (stocks and bonds). Moreover, property rights in the US are secure, and dispute settlement is impartial and reasonably quick compared with other countries (not by an absolute standard). Effective confiscations by Argentina, Bolivia, Russia and Venezuela have reminded savers around the world that foreign private investment is not always secure in emerging markets. Funds for retirement seek security even more than yield.
Some have emphasised the role of foreign central banks in investing in the US, particularly in US Treasury securities. It is true that extensive foreign official investment in the US occurred in this decade. But it has been dwarfed four-to-one by the inflow of private funds, and has never been sufficient to match the current account deficit. While some apparently private inflows were undoubtedly beneficially owned by official bodies – for example, in the oil-exporting countries – the choice of investment has been made by private investment managers. Moreover, some of the official funds compensate for the unwillingness (e.g. in Japan) or the inability (e.g. in China) of private parties to invest abroad, when it is in the country’s long-term interest to do so. Thus even central banks must be viewed as financial intermediaries in a global economy.
Have foreign claims on the US become unsustainably large? Surprisingly, the net international investment position of the US has improved since 2001, despite large and growing current account deficits. Net foreign claims have declined from 23 per cent of US GDP to 17 per cent over the period 2001–2006, despite cumulative current account deficits of 27 per cent of GDP. The explanation lies in capital gains on US assets abroad in excess of capital gains on foreign claims on the US. Some of these capital gains (measured in US dollars) can be explained by a depreciation of the dollar, since most US claims on the rest of the world are denominated in foreign currencies, and the dollar value rises as the dollar depreciates. But that accounts for only about a quarter of the 2001–2006 gain – the rest is due to capital gains on US equity holdings measured in local currency.
The forces of demography and globalisation are deep-seated and long-lasting. They are not likely to disappear soon, and indeed may even strengthen. But will the US produce enough financial assets to satisfy the world demand for them? An interesting feature of foreign investment in the US, private as well as public, has been its concentration on interest-bearing securities. This may slowly change with the growth of sovereign wealth funds and their interest in pursuing higher yield overseas investments. Foreign investment by Americans, in contrast, concentrates on equity investment.
Thus the US serves as a global financial intermediary, exchanging debt for equity, as well as being a destination for net investment. This practice implies that, over time, Americans earn more on their foreign assets than they pay on their liabilities to foreigners. It also implies that foreign claims on the US capital stock are indirect rather than direct. So in reckoning the share of foreign ownership in the US, and the possibility that it may become unsustainably high, we need to look at total financial assets in the US. Due to financial innovation and the development of ever-more refined financial instruments to appeal to diverse tastes, the financial side of the US economy has grown more rapidly than the real side during the past half century, such that by 2006 financial assets amounted to ten times GDP, up from five times in 1965. Foreign ownership of these assets amounted to under ten per cent, but up from four per cent in 1980. The sub-prime mortgage crisis of course signaled that not all of this financial innovation was sound, and some de-leveraging of the US economy may well occur in 2008. However, the long-term trend is likely to resume thereafter. There does not seem to be any shortage of US financial assets in the near term.
Of course, eventually, aging societies will reduce their savings and desire to run down their accumulated assets. At some point the excess savings will disappear, as will the associated current account surpluses. At that point the US deficit will undoubtedly also decline. But that point may not be reached for many years.
Some have advocated that to wait would be unwise, even reckless, since the large deficit might precipitate a ‘hard landing’ for the US economy and for the world. Thus, there are proposals for a large engineered depreciation of the US dollar, combined with reduced spending in the US and increased spending abroad. But depreciation of the dollar implies appreciation of the currencies of the countries in surplus, and that is likely to depress investment in such export-oriented economies as China, Germany and Japan, not stimulate it. And why should aging consumers spend more now rather than save for a retirement of ever-increasing but uncertain length? Furthermore, to avoid world recession, such a package deal would require consummate management of macroeconomic policies across countries. This is improbable and would require larger government deficits in countries such as Germany and Japan, which have been struggling to reduce their budget deficits.
The US has a vibrant, innovative economy. Its demographics differ markedly from those of other high-income countries in that birth rates have not fallen so far, while immigration, concentrated in young adults, can be expected to continue on a significant scale. In these respects the US, although high-income and politically mature, can be said to be a young and even a developing country. It has an especially innovative financial sector, which continually produces new products to cater to diverse portfolio tastes. In a globalised market, the US has a comparative advantage in producing marketable securities and in exchanging low-risk debt for higher-risk equity. It is not surprising that savers around the world have wanted to put a growing portion of their savings into the US economy. The US current account deficit and the corresponding surpluses elsewhere, although conventionally described as imbalances, do not necessarily signal economic disequilibrium in a globalised world economy, and they may well remain large for years to come.